The bull market hit a new level of volatility in February, prompting investors to scramble for cover. The question now is which does a better job of providing cover and shielding investors from risk, a passive or actively managed portfolio?
Financial experts say investors should really be asking whether the securities they choose — no matter how they’re managed — meet or exceed their goals. Passive funds are not regularly managed and aim to match the market or an index, while active funds have managers that try to find the best deals in the market to enhance returns or reduce risk, says Byron Ellis, managing director of United Capital Financial Life Management in Newport Beach, California. “The idea behind this method of investing is that the market is not efficient. Therefore, it can be exploited to render better-than-average returns,” Ellis says.
Whether you should have active or passive investments is essentially a question about risk and management expertise, says Howard Feigenbaum, a registered investment advisor and owner of Sharemaster. Passive funds — such as those that track an index — perform well when the market is good, as it has been over the past several years, and help spread the risk.
The assets you buy and metrics you use, such as dispersion, also play into the equation, says Daniel Lugasi, portfolio manager at VL Capital Management in Orlando, Florida. Dispersion refers to the difference between the best and worst performers in an index.
[See: 10 Ways for Investors to Buy the Market.]
When dispersion is high, active managers that pick stocks tend to outperform, but when dispersion is low, active managers find it harder to choose winners. From 2011 to 2016, 88.3 percent of large-cap active managers, 89.95 percent of mid-cap managers and 96.57 percent of small-cap managers underperformed their respective benchmarks, according to a Standard & Poor’s report.
But now that the U.S. stock market has seen a small correction and more volatility is predicted, active managers may have a better shot of achieving above-average returns (though with bigger expenses and fees). To help you determine whether an active or passive portfolio is right for you, experts offer these tips.
Active accounts are usually better when there is more volatility. During the market’s strong upward trend for almost the past decade, passive investments like index funds and exchange-traded funds have been a superior strategy, says Len Hayduchok, founder and president of Dedicated Financial Services in Hamilton, New Jersey.
But in a declining market, active investing could be the better choice, at least over the next few years when stocks are expected to return below-average gains. “Active funds can make smart use of cash and security selection to help minimize losses in a down market,” says Steve Deschenes, director of product management and analysis with Capital Group in Los Angeles. “Doing better than the market in bad times is one of the best ways to grow and protect your nest egg. Funds with better downside protection help limit losses, making it easier for your nest egg to bounce back.”
And while passive funds generally have lower fees that result in more favorable returns over the long haul, plenty of actively managed funds have lowered their expenses to be competitive and have long track records of providing great returns, says Matthew Murawski, a financial planner with Goodstein Wealth Management in Encino, California.
[See: 8 Tips for Choosing an Active Fund Manager.]
Active managers may act on hunches, too. “The conventional active investor believes in the possession of a superior skill or intellect, which can be used to outsmart the market by seeing things others have missed,” says Tim Baker, director of product strategy for Symmetry Partners in Glastonbury, Connecticut. The problem with that is “at some stage in the decision-making process, the outcome must be interpreted as a reasonable guess, hunch or gut feeling.” That “subjective human element” can result in higher risk.
That’s why selecting a manager with an excellent reputation and performance history can improve your chances. “There are a few select fund managers who can consistently beat the market over time,” says Andrew H. Cohen, a fellow at Old Dominion University in Norfolk, Virginia.
Fund managers with expertise in certain industries can also put that knowledge to work for you. “If an investor has an information edge from working in a particular industry, then the investor can reap excess returns by seeing trends before the overall market reacts,” Cohen says. The best fund managers keep costs low and invest their own money in the fund alongside investors, Deschenes adds. As with any investment, future returns are never guaranteed.
These investing styles aren’t mutually exclusive. Just as diversifying asset classes and investment types is important, so is diversifying your mix of active and passive holdings. “It’s not either/or,” says Adam Taback, head of global alternative investments at the Wells Fargo Investment Institute in Charlotte, North Carolina. “As we enter the later stages of an economic cycle, securities start being more discriminating in returns and fundamentals matter more, which makes active management all the more important.” Passive investing, though, still has opportunities in certain spaces, he says.
Investors may want to hedge their bets and split the portfolio so that it includes both passive and active funds. “This way, you win when active outperforms passive, and you win when passive outperforms active,” says Gabriel Pincus, president of GA Pincus Funds.
The person managing your portfolio must always be you. No matter how you invest, your portfolio should always be managed and reviewed by you first and foremost, says John Ingoglia, president of Socotra Capital. “It’s always good to have advisors, but at the end of the day, trust no one but yourself. Never delegate this responsibility, or avoid checking on it out of fear of how bad things are or might get.”
[See: 7 Bad Investing Habits That Are Holding You Back.]
Going overboard with your responsibility is just as bad as shirking it. Adjust or balance your asset allocations once or twice a year and no more, Ingoglia adds. “Unless you see a major deficiency or flaw in your strategy, let the investments you choose play out,” he says. “Review and keep track of your investments like it’s part of your business. Check up once a month at minimum, to ensure everything is running smoothly. Try not to touch it. Steady and focused is the game.”
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